Company Information

Contact

This essay has been submitted by a law student. This is not an example of the work written by our professional essay writers.

Published: Fri, 02 Feb 2018

Restriction on transfer of shares

Restriction On Transfer Of Shares In A Private Company

Introduction:

Philosophical Foundations Of Transfer Of Shares In A Private Company

The intention behind a modern private company is dual: Firstly, to facilitate small traders or private persons carrying on a family business to avail of the advantages of corporate trading. Secondly, to act as a subsidiary in a group of companies so as to avoid having to establish a public company, given the plethora of exacting requirements they are required to follow.

Now, section 3 of the Companies Act, 1956 (hereinafter, ‘the Act’) defines a Private Company. The main characteristics of private companies that emerge from a perusal of this definition relevant to the discussion at hand are:

Restrictions on the rights of members to transfer their shares

Limitation of the number of members to 50.

A prohibition on the public subscription of its shares or debentures as also acceptance of deposits from the public.

In view of the definition, a private company is required by law to incorporate certain specified restrictions, prohibitions and limitations with regard to transfer of shares in its Articles of Association. Section 27(3) further endorses and states that a private company limited by shares must have articles containing the regulations required by Section 3(1)(iii) clauses (a), (b) and (c); while other forms of private companies must have in its articles the regulations contained in clauses (b) and (c) of Section 3.

It is to be noted the transferability of shares is one of the most vital features of a company. This is iterated in Section 82 of the Act, echoing the philosophy relating to transfer of shares given in Palmer’s Company Law where it is stated:

“It is well settled that unless the articles provide otherwise the shareholder has a free right to transfer to whom he will. It is not necessary to seek in the articles for a power to transfer, for the Act itself gives such a power. It is only necessary to look to the articles to ascertain the restrictions, if any, upon it. Thus, a member has a right to transfer his shares to another person unless this right is clearly taken away by the articles”.

In order to truly comprehend the ‘transfer of shares in private companies’ the focus has to be on the ‘restrictions on transfer of shares’ in these companies. This project seeks to explore the rationale for such restrictions, the types of restrictions and the ambiguities that stem from such restrictions. Finally, the researcher concludes by examining the statutory and institutional mechanisms available to check such vagrancies. The scope of this project is limited to an analysis of the transfer of shares in private companies. The law relating to transfer of shares in public companies has not been explored in detail. Moreover, the American position with respect to transfer of shares in ‘close corporations’ has not been looked at.

Issues

What is the concept of private companies?

What exactly does a transfer of a share entail?

Why does a private company need to incorporate restrictions on transfer of shares in its articles?

What are the various types of restrictions on transfer of shares in private companies?

What are the implications and important issues related to these restrictions?

What are the various remedies available to the aggrieved persons when the company refuses to register transfer of shares?

Research Methodology

The researcher has followed the doctrinaire method of research. The project is analytical as well as descriptive in nature. Primary resources such as the Indian Companies Act 1956 have been used. Besides this, secondary resources have been referred to. A host of leading textbooks on Corporate Law as well as relevant articles from leading Law Journals have been referred to. Case reporters like Supreme Court Cases, All England Law Reports, Company Cases and All India Reporter have been used.

Need For Restriction On Transfer Of Shares: The ‘Soul And Basis’ Of A Private Company

Section 3(1)(iii)(a) of the Act provides that the Articles of a private company shall restrict the right to transfer the company’s shares. Typically, a family or other private group may own 100% shareholding of a private company. Hence, in the United States private companies are referred to as ‘Close Corporations’. Bonds of kinship, friendship or similar close ties usually unite the members of a private company. In this scenario, the transfer of shares to a stranger would be undesirable, unless the existing members accept his admission. Observance of such regulations allows private companies to meet the goals and purposes for which they are set up.

The Act compulsorily requires private companies to impose restrictions on the transfer of shares by incorporating such restrictions in their articles. However, the Act does not specify any particular mode of restriction or prescribe the extent of the restriction required. Thus the restrictions may be as slight or as severe as the framers of the articles desire. Such restrictions should be general and apply unvaryingly to all shareholders and types of shares.

In V.B Rangaraj v. V.B Gopalakrishnan and Others the Supreme Court held that shares are movable property and the articles regulate their transfer. The articles are the regulations of the company, binding on both the company and its shareholders. Therefore, the only permissible restrictions on the transfer of shares are those, which are contained in the Articles. An additional restriction not contained in the articles but in a private agreement between two shareholders, which places further obstacles in the way of transferability, is not binding either on the company or the shareholders. The transferee cannot be denied the registration of the shares purchased by him on a ground other than stated in the Articles.

Contrasting Transfer Of Shares In A Public Company With That In A Private Company

The above-discussed feature is what differentiates private companies from public companies, which have no restrictions on the right of their members to transfer their shares. Section 111A(2) provides that the shares or debentures of a public company shall be freely transferable. In a public company there is no control over whom the shares are transferred to on the stock exchange. This is unlike the controls on a private company’s transfer of shares through preemptory rights and approval of the board of directors (hereinafter ‘directors’). Infact, it is provided that if a company refuses to register transfer of shares without sufficient cause, within two months from the date on which the instrument of transfer or the intimation of transfer is delivered to the company, the transferee can appeal to the Company Law Board. The Act states that the Board shall direct such offending company to register the transfer of shares.

These restrictions on transfer of shares in private companies flow from the Partnership Principle, which is the soul and basis of private companies. In economic terms, a private company can be so construed so as to amount to nothing more than incorporated partnerships with particularly close ties between the members. These restrictions on transfer of shares helps keep the ‘soul and basis of the company’ intact.

Restriction Not Prohibition

These restrictions are not to be construed as a ban or a prohibition on the transfer of shares. The Courts have consistently held that the restriction upon transfer means any restriction that will give some control to the company over transferability of shares. It was held in Chiranji Lal Jasrasaria v. Mahabir Dhelia that a restriction which amounts to a prohibition on transfer of shares or which precludes a shareholder altogether from transferring is invalid. Moreover, a prohibition on the transfer of shares will amount to violation of Section 82 of the Act and Section 6 of the Transfer of Property Act, 1872.

It is relevant to note that restrictions upon transfer of shares in private company are inapplicable in the following cases:

(i) On a member’s right to transfer his shares to his representatives.

(ii) In the event of death of a shareholder, legal representatives may require the registration of share in their name. Transferability is the general nature of property and even when there is a restriction on transfer, when the person dies the restriction will not apply.

Types Of Restrictions On The Transfer Of Shares In A Private Company

Restrictions on the shareholder’s right to transfer their shares has two common forms:

Right of Pre-emption in favor of the other members

Powers of the Board of Directors to refuse to register transfer of shares

Let us now explore these two forms of restriction in some more detail.

Pre-Emption Clause

In Bishan Singh v. Khazan Singh the Court stated that the right of pre-emption is not a right to the thing sold but a right to the offer of a thing to be sold. The most frequent type of transfer restriction is the right of pre-emption. The pre-emption clause in the articles generally provides that when a member wishes to sell some or all of his shares, he shall first offer them to the other members for purchase at a price ascertained in accordance with a formula set out in the articles, or at a fair price at which the shares are valued by the directors or by the company’s auditors and he shall transfer the shares to his proposed transferee only if the other members do not exercise their right of pre-emption.

The pre-emption clause goes a long way in ensuring that the control of the shares does not fall into the hands of undesirable persons by allowing the existing shareholders the first opportunity to buy the shares.

Various types of pre-emption clauses are found in the articles of private companies. Such as a provision that the proposing transferor shall first offer the shares to all other shareholders; or that he is entitled to select the shareholder to whom he wants to sell; or the first offer has to be made to certain enumerated shareholders e.g., those holding founder’s shares; or the articles provide that in certain circumstances e.g. in the case of death of a member, the surviving members or directors are obligated to acquire the deceased member’s shares.

In addition, these pre-emption clauses are supplemented with a general restriction clause, for instance, after the failure of those entitled to pre-emptive rights to acquire the shares and their subsequent offer to another person, the directors may decline the transfer. There is no doubt as to the validity of these pre-emption clauses and courts have consistently upheld the validity of the pre-emption clause in the article of a private company.

Implementation Of Pre-Emptive Rights: Procedure For Transfer Of Shares In A Private Company

As stated above, the transfer of shares in a private company, are governed by the articles of the company. Where the articles provide a procedure for implementation of pre-emptive rights the procedure laid down has to be followed. The steps followed by a private company to give effect to the transfer of shares if the articles contain a pre-emption clause are genrally as follows:

(i) Transferor should give a notice in writing to the company stating his intention to transfer his shares.

(ii) The company should in turn notify the other members of the availability of such shares and the price at which they will be available; along with the time limit within which they should communicate their decision to purchase such shares.

(iii) The price is determined by the company’s directors or auditors. Normally, articles of a private company contain provisions in this regard and provide that the shares are to be sold at a fair price as determined by directors or the company’s auditors.

A member cannot elude a provision for pre-emption in the articles by executing an instrument of transfer to such a person, with the intent that the purchaser shall not apply for registration as a member, but be satisfied with the transferor holding the legal title to the shares as a bare trustee for him. It has been held that a pre-emption provision was adhered with where one member sold to another member even though an outsider paid the purchase price and it was the transferee who was to vote at the outsider’s discretion.

It is humbly submitted that the decision of the Court to recognize this as a valid transfer and to hold it in compliance with the pre-emptive clause is erroneous. The decision goes against the purpose of the pre-emptive clause i.e., to prevent outsiders and undesirable persons from gaining control of the company. In this case, although the pre-emptive provision was complied with in form it was violated in substance. The court should have looked at the substance of the matter and not the form.

Now moving to the second way in which a restriction can be exercised on the transfer of shares in a private company.

Power Of The Board Of Directors To Refuse To Register Transfer Of Shares

The articles of a private company commonly vest the Board of Directors with discretion regarding the acceptance of a transfer of shares. This power vested in the Board is fiduciary in nature i.e., it must be employed in good faith and for the benefit of the company and not for some inappropriate purpose. The consequences of the directors abusing this power and the remedies available to the aggrieved persons have been dealt with below.

Exercise Of Power Of Refusal

The directors exercise their right to decline to register a transfer of shares only by passing a resolution to that effect; mere failure, due to a deadlock to pass a resolution is not a formal, active exercise of the right to decline and thus the applicant will be entitled to be registered as a member of the company.

Burden Of Proof

The burden of proving that the directors have wrongfully accepted or objected to transfers of shares rests on the person making the allegation. The Courts will always presume bona fide on the part of the directors.

According to Section 111(1) of the Act, the Board of Directors must exercise their power of refusal within two months from the date of receiving the application. The question that now arises is that if the directors do not exercise their power of refusal then on the expiry of the two months does the company lose the right of rejection and the transferees get a vested right? Can they go ahead and register themselves?

Section 111 is silent regarding this question. When faced with this issue the Bombay High Court neither agreed to the argument that the company would lose the right of rejection nor that the transferee would acquire a vested right to the shares. It is thought that in such cases a court order would be necessary and a decision should be made on merits.

Thus, the transferee has to silently wait out the reasonable period of two months, which is given to the directors to make their decision and can resort to legal proceedings only after this period has expired. A belated exercise of the power of refusal by the Board will be looked upon with suspicion by the Court and will strengthen the position of the aggrieved transferee.

Use Of Judicial Sword Against Shield- Abuse Of Power Of Board Of Directors To Refuse To Register Transfer Of Shares And Remedies

As discussed above, private companies are required by law to incorporate into their articles restrictions on the transfer of shares. A common form of these restrictions is the power conferred on the directors to refuse to register a transfer. Very often the articles of a private company may vest absolute discretion in the directors to refuse to register transfer of shares.

In Balwant Transport Company v. Deshpande, the Nagpur High Court felt it would not be justified for the Court to interfere with the director’s bona fide exercise of their discretion. This is based on the Court’s belief that it is the directors who know what is in the best interest of the company and thus, it is inadvisable for the Court to substitute their opinion for the board’s.

However, the Board of Directors does not always exercise its powers of refusal in good faith or bona fide. In the name of acting in the interests of the company the Board may abuse its power and refuse to register transfer of shares. The fact that close ties of kinship and friendship generally bind the directors in a private company would make such abuse easier. They may conspire to refuse to register a transfer based in say personal hostility towards the transferee and subsequently use the defense of acting in the interests of the company as a shield. Such acts may prejudicially affect the interests of genuine transferees and shareholders as well as those of the company.

Section 111 of the Act seeks to prevent this abuse by the directors and ensure that the interests of genuine and bona fide transferees and shareholders are not adversely affected. Section 111 provides a right of appeal to the Company Law Board (hereinafter, ‘CLB’) in respect of refusal to register transfer/transmission of shares and Section 111A gives the right to petition the CLB for rectification of register of members. This right has been iterated even in clause 52 of the recent Companies Bill, 2009.

There are several grounds on which such an appeal to the CLB can lie. Firstly, when it is found that the board of directors has acted with mala fide. In Harinagar Sugar Mills v. Shyam Sunder the Supreme Court stated that while exercising its appellate jurisdiction under Section 111 the CLB has to decide whether in exercising their power the directors are acting, oppressively, capriciously, or corruptly or in some way mala fide. Secondly, the CLB can exercise its jurisdiction if it is found that the board has not disclosed sufficient reasons to justify its refusal to accept the transfer of shares. By virtue of the 1988 Amendment to the Act, the board is bound by law to disclose its reasons for refusing to register a transfer of shares. This gives an opportunity to the CLB to examine the relevancy of the reasons given by the board and ensure basic adherence with the principles of natural justice.

The third ground based on which the CLB can exercise its jurisdiction is when it finds that the board has exercised its power of refusal based on irrelevant considerations, grounds which are not specified in the articles. Lord Greene MR in Smith and Fawcett Ltd., Re stated, “The directors (in refusing a transfer) must have regard to those considerations and those considerations only which the articles on their true construction permit them to take into consideration”. The Calcutta High Court in Master Silk Mills Private Limited v. D.H Mehta has followed the same line of reasoning. Here the board refused to accept a transfer in favor of another company whereas the articles empowered them to exclude only undesirable persons. The Court held that such blanket ban on admission other companies was beyond the authority vested in the board by the articles. The Court stated “Approval of the transferee means approval of the transferee personally as distinguished from laying down a general rule that no corporate body would be allowed to join the company as a shareholder”. This decision is extremely well analyzed and clearly lays down the principle that if the directors exceed the power of refusal granted to them by the articles the court will strike down their order refusing to register transfer of shares.

It is thus seen that the Act has vested the CLB with the appropriate judicial sword in order to mete out justice and remedy wrongful refusals by the directors. The Courts too have implemented the law zealously and interpreted the legislative provisions to ensure justice is meted out and the rights of the Company, shareholder and the injured transferee are not affected adversely.

Conclusion

The core issue with respect to transfer of shares in private companies is the restrictions on this transfer of shares, which a private company must mandatorily incorporate into its articles as per Section 3(1)(iii)(a) of the Act. It must be noted that the Act does not specify the exact form of these restrictions. Consequently, it is open to the framers of the articles to design these restrictions and clarify their scope and extent.

Such restrictions on the rights of the members to transfer their shares is one of the main characteristics of a private company and is considered something intrinsic to a private company given that it is based on the partnership principle. In fact, it is said that the partnership principle is the soul of a private company. A private company is usually an association of persons bound together by close ties of kinship, friendship and sharing a camaraderie and trust, which cannot be easily shared with another person. This restriction on transfer of shares allows the members of a private company to thwart admission of members who may be unfavorable or hostile to the existing members and thus, checks the dilution of control over the company by the current members. The Courts have proved to be the guardians of these restrictions and have preserved the soul of the private company and consequently enabling the private company to achieve its aims and objectives.

However, there are certain problems that threaten this continued preservation of the soul of a private company. These restrictions create some areas of uncertainty, which in turn create problems in company law and affairs. For example there is ambiguity with respect to valuation of shares in the case of exercise of pre-emption rights. Moreover care must be taken to see that these restrictions do not exceed the scope prescribed by the articles, as this could hamper the rights of the shareholders, transferees and thus, the company may be adversely affected. The power vested in the directors to refuse to register a transfer is a common restriction found in the articles of a private company. The Board often abuses this power. The 1988 amendment, which requires the Board to give reasons for its refusal, has helped to check the abuse of this power. However, we must not become complacent and should constantly search for innovative means of checking such abuse. Section 111 of the Act adequately provides for the remedies available in case of abuse of this power. The Courts too have done their best to check abuse of this power and ensure that no injustice or prejudice is caused to the aggrieved person.

Besides the statutory mechanism available to control vagrancies, it is important that companies themselves take the initiative and draft these restrictions with utmost care and foresight. Illustratively, the abuse of the power to refuse to register a transfer by the board would be considerably reduced if proper guidelines were incorporated into the articles with respect to the exercise of this discretion.

Concrete steps must be taken to rectify abuse and to clear the ambiguous areas created by these restrictions on the transfer of shares in private companies. It is indispensable for the smooth working and success of private companies and consequently is in the larger interest of the Indian economy!